Overview… What is the Basel III framework relating to.... Definitions of the three pillars and relationship among the three Significant methods of measurement of each one of them Challenges in implementation of these norms Indian scenario
What is "Basel III" A global regulatory standard on bank capital adequacy stress testing and market liquidity risk With a set of reform measures to improve Regulation supervision and risk management
Reasons for formulation of Basel III (failure of basel II)
Reducing profitability of small banks and threat of takeover Lack of comprehensive approach to address risks Self-regulation in area of asset securitization Lack of safety Inability to strengthen the stability of financial system Failure to achieve large capital reductions
Aim To minimize the probability of recurrence of crises to greater extent To improve the banking sectors ability to absorb shocks arising from financial and economic stress. To improve risk management and governance To strengthen banks transparency and disclosures.
Target Bank-level, or micro prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress. Macro prudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.
Micro- prudential elementsTo minimize the risk contained with individual institutionsThe elements are: Definition of capital Enhancing risk coverage of capital leverage ratio International liquidity framework
Macro- prudential elements To take care of the issues relating to the systemic riskThe elements are: Leverage ratio Capital conservation buffer Countercyclical capital buffer Addressing the procyclicality of provisioning requirements
Cont’d Addressing interconnectedness Addressing the too- big to- fail problems Addressing reliance on external credit rating agencies.
Definition of the three pillars
Pillar 1- Minimum Capital Requirements• calculate required capital• Required capital based on Market risk Credit risk Operational risk• Used to monitor funding concentration
Pillar 2- Supervisory Review Process Bank should have strong internal process Adequacy of capital based on risk evaluation
Pillar 3 – Enhanced Disclosure Provide market discipline Intends to provide information about banks exposure to risk
The relationship among the three Second pillar – supervisory review process to ensure the first pillar - intended to ensure that the banks have adequate capital Third pillar – compliments first and second pillar - a discipline followed by the bank such as disclosing capital structure, tier-i and tier-ii capital and approaches to assess the capital adequacy i.e. assessment of the first pillar. Model of commercial banks interpret first pillar as a closure threshold rather than bank’s asset allocation
Significant Methods of Measurement
The pillar is divided in three types of risk for which capital should be held. Credit Risk Operational risk Market risk
Credit Risk… Credit risk is the risk that those who owe you money will not pay you back. Historically credit risk is the larger risk banks run.BIS II proposes three approaches by which a bank may calculate its required capital for credit risk. Standardized approach Internal rating based (IRB) advanced Internal rating based (IRB) foundation
Operational Risk… Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.Comparable to credit risk, BIS II proposes three methods for measuring operational risk. Basic indicator approach Standardized approach Advanced measurement approach (AMA)
Market Risk… Market risk is the risk of losses due to changes in the market price of an asset. Market risk will only have to be calculated for assets in the trading book. Foreign exchange rate risk and commodities risk are part of the market risk.Two methods may be used: Standardized measurement method Internal models approach
Challenges in implementation of basel 3 norms
• The new and stricter regulations of the basel3like higher capital requirements, the new liquiditystandard, the increased risk coverage, the newleverage ratio or a combination of the differentrequirements will be difficult to adopt by the banks• Banks have to take a number of actions to meetthe various new regulatory ratios, restoring of data,• Banks must be able to calculate and report thenew ratios. Which requires the hugeimplementation effort.
Challenges of basel3implementation:Banks usually have 3 types of challenges1. Functional challenges2. Technical challenges3. Organizational challenges
Functional challenges•Developing specifications for the new regulatoryrequirements, such as the mapping of positions (assetsand liabilities) to the new liquidity and fundingcategories in the LCR and NSFR calculations.•the specification of the new requirements for tradingbook positions and within the CCR framework (e.g.CVA) as well as adjustments of the limit systems withregard to the new capital and liquidity ratios.•Crucial is the integration of new regulatoryrequirements into existing capital and risk managementas some measures to improve new ratios (e.g. liquidityratios) might have a negative effect on existing figures.
Technical challenges•The technical challenges includes the availability ofdata, data completeness, and data quality and dataconsistency to calculate the new ratios.• The financial reporting system with regard to the newratios and the creation of effective interfaces with theexisting risk management systems.
Operational challenges • The operational challenges includes stricter capital definition lowers banks’ available capital. At the same time the risk weighted assets (RWA) for securitizations, trading book positions and certain counterparty credit risk exposures are significantly increased. • The stricter capital requirements, the introduction of the LCR and NSFR will force banks to rethink their liquidity position, and potentially require banks to increase their stock of high-quality liquid assets and to use more stable sources of funding.
•Basel III also introduces a non-risk basedleverage ratio of 3 percent. Group1 banks arefailed in maintaining the this leverage ratio•The banks will experience increased pressure ontheir Return on Equity (RoE) due to increasedcapital and liquidity costs, which along withincreased RWAs will put pressure on marginsacross all segments
Capital… Indian banks need to raise Rs 1.5 lakh crore to Rs 1.75 lakh crore as capital to meet the BASEL- III requirements. Can PSU banks mobilize this sort of capital? - Probably NO, The alternate to the government is either to reduce shareholding below 50% or slowdown PSU growth Can private banks raise this sort of money? - They probably can, because Rs 500 billion was raised in last 5 years
Problems for PSUs Capital adequacy ratio - has been stipulated at 9%, unchanged from what the regulator requires in India currently, banks here will need to raise more money than under the current Basel II norms because several capital instruments cannot be included under the new definition.Ex: Perpetual Bond Maintaining an 8% tier I capital ratio More additions to non-performing assets Unamortized expenditure on pension liabilities
The Indian economy is also expected to grow atan annual growth rate of 8-9% for next 10 yearsor so. This would undoubtedly necessitate aconsiderable growth in bank capital.
Issues relating to SLR and LCR…. India, banks are statutorily required to hold minimum reserves of high-quality liquid assets at 24% of net demand and time liabilities. The proportion of liquid assets in total assets of banks will increase substantially, if the SLR reserves are not reckoned towards the LCR (Liquidity coverage ratio) and banks are to meet the entire LCR with additional liquid assets, thereby lowering their income significantly. RBI is examining to what extent the SLR requirements could be reckoned towards the liquidity requirement under Basel III.
Profitability …. Retail banks will be affected least, though institutions with very low capital ratios may find themselves under significant pressure. Corporate banks will be affected primarily in specialized lending and trade finance. Investment banks will find several core businesses profoundly affected, particularly trading and securitization businesses. Balance sheet restructuring and business-model adjustments could potentially mitigate up to 40 percent of Basel III’s RoE impact, on an average. Government banks may have to sacrifice growth
Cont’d… The impact of credit requirements on the profitability of banks would depend upon sensitivity of lending rates to capital structure of banks and sensitivity of the credit growth to the lending rates. When banks with low core Tier I shore up their capital to around 9% required, their return on equity (RoE) could drop by 1-4%. Basel III will force banks to plough back a larger chunk of their profit into the balance sheet. Banks might have to rationalize dividend policies so that more profit could be retained and used as capital, indicating a lower dividend for the government.
Benefits of Implementation… Demonstrate that the banking system is recovering well from the global financial crisis of 2008 and has been developing the resilience to future shocks. Contribute to a bank’s competitiveness by delivering better management insight into the business, allowing it to take advantage of future opportunities. Strengthen the financial system of both developing and developed countries by addressing the weaknesses in the measurement of risk under Basel II framework revealed during
Cont’d… Delivers a much safer financial system with reduced probability of banking crises at affordable costs. The impact of costs is minimized through long phase-in. It is expected that as the proportion of equity in the capital structure of banks rises, it would reduce the incremental costs of raising further equity as well as non-common equity capital.
The Reserve Bank’s approach has been toadopt Basel III capital and liquidity guidelineswith more conservatism and at a quickerpace. The impact of these rules is not going tobe onerous and there will be considerableadvantage in adopting Basel III by our banks.